Are You Getting the Most Out of Your 401k?

Let's face it: Most people who are working today cannot depend on a traditional employer pension for retirement, and the future of Social Security is in doubt. Americans know this, and yet a frighteningly high percentage of us choose not to participate in our employer-sponsored savings plans, such as the 401k.

Well, its time to stop procrastinating. If your employer does offer a 401k, its time to sign up and begin saving. In most cases, a 401k is a great investment vehicle for retirement saving and should not be ignored.

What is a 401k?

Over the course of the past 25 years, employers have increasingly moved away from so-called "defined benefit" pension plans toward "defined contribution" plans. Under and old-style, defined benefit plan, the employer was responsible for a set monthly payment and benefits for retirees. These are the type of pensions that have Ford and GM in serious trouble.

Defined contribution plans, in contrast, simply require the employer to make a set contribution to an employee's retirement savings throughout the employment of the worker. The most popular defined contribution plan is the 401k, so named for its chapter in the tax code.

For example, an employer may offer a 401k match. In this case, the employee may decide to contribute 11 percent of his earnings to his 401k and the employer agrees to match all contributions up to six percent.

The employer can choose to offer a match up to a set percentage of earnings or choose not to offer a match at all, but it must make the same matching plan available to all employees on a non-discriminatory basis. In this way, the 401k is said to be a non-qualified plan.

The 401k - Pros...

To the employee, the biggest advantage of a 401k is the employer match--assuming, of course, that the employer does offer a match. With few exceptions, everyone should fully fund their 401k to the maximum of their employer's match. Otherwise, the employee is just throwing away free money.

To both the employer and the employee, the 401k offers the benefit of tax-exemption. The employee's contributions are tax-deductible, meaning that all contributions to a 401k do not face personal income tax, although they do face Social Security and FICA tax.

To the employer, the deal is even better, as they are not even responsible for their half of Social Security and FICA taxes on contributions to employee's 401k's. This makes funding an employee's 401k less expensive to an employer than paying the employee in salary.

Finally, employees own their 401ks--as opposed to traditional pensions, which are the property of the sponsoring corporation. An employee's own contributions are immediately his or her own, while an employer's contributions are vested over time.

Practically speaking, this means that an employee of five or more years typically owns his entire 401k, even if he or she were to be fired. In fact, the 401k is transferable to a person's heirs upon death, whereas traditional pensions may pay a survivorship benefit only to the holder's spouse in most cases.

... And the Cons

On the negative side, 401k holders are usually limited in their investment choices. This shortcoming is most evident when the employer does not offer to match employee contributions. In such a scenario, the employee is probably better off fully funding a self-directed Roth IRA, in which he or she will have more control over their investments.

Furthermore, while withdrawals from a Roth IRA are completely tax-free upon retirement, 401k withdrawals are fully taxable at the individual's personal income tax rate. For most people, this makes a Roth IRA a better vehicle than the 401k.

However, if your employer does offer a match, you should almost definitely take advantage of it. Even putting money into a savings or money market account guarantees a strong return when your employer is offering a match. Furthermore, you can (and should) have a Roth IRA on the side.

So now that you know some of the facts behind the 401k, see your HR person as soon as possible and get signed up. It's never too late to begin preparing for your retirement, but earliest is best. Don't wait another day to start your 401k!

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